University of Agriculture Faisalabad

University Of Agriculture Faisalabad

Assignment 3 20/04/2020

Class: M. Com 4th

Subject: Islamic Finance

Teacher: Prof. Abdul Moueed sb

Submitted by: Ali SHER ( 2018-ag-3423)

Question 1:

Name the different Trade based modes of Islamic finance? Define and
explain Murabahah. Explain the different stages of Murabahah. Further, discuss
three models of Murabahah in detail?

Ans No. 1:
Different Trade based modes of Islamic finance:
Trade based modes of financing became available in the market much later than
partnershipbased mode, but its products gained dominance among other products very
quickly. Because ittargeted a much larger group of investors, both private and business
customers, and it also issafer for both parties to invest in this mode of financing, compared to
partnership based mode.

1- Murabaha Finance:

2- Salam Finance:

1- Murabaha Finance:

Definition:
Murabaha( also referred to as cost-plus financing) is an Islamic financing structure in which the
seller and buyer agree to the cost and markup of an asset. The markup takes place of interest,
which is illegal in Islamic law. As such, murabaha is not an interest-bearing loan (qardh ribawi)
but is an acceptable form of credit sale under Islamic law. As with a rent-to-own arrangement,
the purchaser does not become the true owner until the loan is fully paid.

Explaination of Murabahah:
Murabaha is an agreement between a bank and its customer. The customer requests the bank
topurchase or import commodities on his/her behalf, with a promise to buy them from the
bank atpurchase price plus profit margin of the bank, and to be paid on deferred installments.
One of themost used forms of Murabaha by Islamic banking customers is home financing.
Murabaha couldbe named as the locomotive of Islamic finance because it was after the
introduction of Murabahathat Islamic banking assets grew at double digits. But there
are numbers of critics among prominent scholars criticizing Murabaha’s compliance
with Shariah. As Usmani states, “Itshould never be overlooked that originally,
Murabaha is not a mode of financing. It is only adevice to escape from ‘interest’ and not an
ideal instrument for carrying out the real economicobjectives of Islam.

KEY TAKEAWAYS

 Interest-bearing loans are prohibited under Islam’s Sharia law.

 In Islamic finance, murabaha financing is used in place of loans.
 Murabaha is also referred to as cost-plus financing because it includes a profit markup in
the transaction rather than interest.
 A seller and buyer agree to the cost and the markup, which are then paid in installments.
Use of Murabaha:
The murabaha form of financing is typically used in place of loans in diverse sectors. For
example, consumers use murabaha when purchasing household appliances, cars, or real estate.
Businesses use this type of financing when purchasing machinery, equipment, or raw materials.
Murabaha is also commonly used for a short-term trade, such as issuing letters of credit for
importers. A murabaha letter of credit is issued on behalf of an applicant (importer). The bank
issuing the letter of credit agrees to pay an amount of money in compliance with the terms
described in the letter of credit. Because the bank’s creditworthiness replaces that of the
applicant, the beneficiary (exporter) is guaranteed payment. This benefits the exporter because
the bank assumes the payment risk.
Example of Murabaha:
Bilal would like to buy a boat that sells for $100,000 from Billy's Boat Shop. To do so, Bilal
would contact a murabaha bank, that would buy the boat from Billy's Boat Shop for $100,000
and sell it to Bilal for $109,000, to be paid in installments over a three year period. The amount
Bilal pays is a fixed amount to a bank that owns the asset and there is no interest charge
involved. Also, if Bilal defaults on any payments, there are no additional charges that he would
incur. The additional amount Bilal pays over the cost price from the boat shop is in effect a 3%
loan, but because it is offered as a fixed payment without any additional costs, it is allowed by
Islamic law.

Different stages of Murabahah:

 1. Promise Stage
 2. Agency Stage
 3. Acquiring Possession
 4. Execution of Murabaha
 5. After Execution of Murabaha

1- Promise stage:

 Stage One (c) for Murabaha financing.

• Client submit the purchase requisition to the bank.
 The Client requests the institution to buy certain goods for him and then sell him (client)
the same after acquiring. The prerequisite is that the goods are not already owned by the
client.
 At this stage the customer promises the institution to buy the goods which were acquired
by the institute on his request.

2- Agency stage:

 Stage Two (a) for Murabahah financing.

• Client appointed as agent to purchase goods on bank’s behalf

 Stage Two (b) for Murabahah financing.

• Bank gives money to supplier through client’s account for purchase of goods.
3. Acquiring Possession:

 Stage three for Murabahah financing.

• Client purchases goods on bank’s behalf and takes their possession.

4. Execution of Murabahah;

 Stage four (a) for Murabahah financing.

• Client makes an offer to purchase the goods from bank.
 Stage four (b) for Murabahah financing.
• Bank accepts the offer and sale is concluded.
• Client pays agreed price (cost + profit) to bank according to an agreed schedule.
Usually on a deferred (in future) payment basis called (Bai Muajjal).

5. AFTER EXECUTION OF MURABAHA:

Securities Against Murabaha Price

■ The institution may ask the customer to furnish (Provide) a security to its satisfaction for
prompt payment of the deferred price.
■ However, it is also permissible that the customer furnishes a security at earlier stages but
after the Murabahah price is determined.
■ It is also permissible that the sole commodity itself is given to the seller as a security.
■ It is preferable not to take Interest bearing instruments as securities (bonds, debentures).

In Case Of Default:

■ In the case of default by the buyer (client) in the payment of price at the due date, the
price cannot be increased.
■ However if he has undertaken, in the agreement to pay certain amount (Fine) for a
charitable purpose, he shall be liable to pay the amount undertaken by him.
■ But this recovered amount from the buyer will not be considered penalty nor
compensation, therefore it will not account to institutions income.
■ Institution is bound to spend it for a charitable purpose on behalf of the buyer.

MODELS OF MURABAHAH FINANCE:

MODEL – I
TWO PARTY REALTIONSHIP

■ Bank – Customer

MODEL – II
THREE PARTY RELATIONSHIP

■ (Bank-Vendor) and Customer

MODEL - III

THREE PARTY RELATIONSHIP

■ Bank and (Vendor-Customer)

MODEL – I:

■ The simplest possible model emerges when the transaction involves two parties only, i.e.
Bank and the Customer.
■ The Bank is also vendor and sells the Asset(s) to its Customers on deferred payment
basis.
■ From Shariah perspective it is an ideal Model and its profits are fully justified because
Bank assumes all risks as Vendor/Trader.

MODEL I – PHASES:

Phase 1:

The customer approaches Bank (Vendor) and identifies Asset(s) and collects relevant
information including cost and profit.

Phase 2:

Bank sells Asset(s) to the Customer, transfer risk and ownership to the Customer at
certain Murabahah Price.

Phase 3:

Customer pays Murabahah Price in lump sum or in installments on agreed dates.

MODEL – II:

■ In most cases Murabaha Transaction involves a third party (i.e. Vendor) because Bank is
not expected to engage in sale of variety of products required for variety of Customers.
■ The Bank directly deals with the Vendor and purchases the Asset(s).
■ The Bank sells the purchased Asset(s) to the customer on cost plus Profit basis.
■ There are two distinct sale contracts at different point of times. First between Bank and
Vendor and second between Bank and the Customer.

MODEL II – PHASES:

Phase 1:

Customer identifies and approaches the Vendor or Supplier of the Asset(s) and collects
all relevant information.
Phase 2:

Customer approaches the Bank for Murabahah Financing and promises to buy the
Asset(s).

Phase 3:

The Bank makes payment to vendor directly.

Phase 4:

Vendor delivers the Asset(s) & transfers the ownership of Asset(s) to the Bank.

Phase 5:

Bank sells the Asset(s) to Customer on cost plus basis and transfers ownership.

Phase 6:

Customer pays Murabahah Price in lump sum or in installments on agreed dates.

MODEL III – BANKING MURABAHA:

■ This Murabaha Model is mostly practiced model in Banking now a days and therefore
we will look at it in more detail.
■ We will also look at the documentation required at different stages of the transaction.
■ It is also a three-party structure but it is bit complicated than previous ones.
■ It is a bunch of contracts completed in steps and ultimately suffices (fulfill) the financial
needs of the client.
■ THE SEQUENCE OF THEIR EXECUTION IS EXTREMELY IMPORTANT TO
MAKE THE TRANSACTION SHARIA’H COMPLIANT.

PHASE I – PROMISE TO PURCHASE AND SELL:

■ The Customer approaches the Bank for Murabaha Finance and promises to purchase the
Asset(s) from the Bank which, the Customer will purchase as an Agent of the Bank.
■ Master Murabaha Finance Agreement (MMFA) shall be signed by the Bank and the
Customer at this stage. This is basically a Memorandum of Understanding between two
parties.

PHASE II – APPOINTMENT OF AGENT:

■ In the absence of expertise required to purchase particular kind of Asset(s), the Bank
appoints Customer as its Agent to buy Asset(s) on its behalf .
 ■ The appointment of an Agent for purchase of Asset(s) for and on behalf of the Bank and
the ultimate sale of such Asset(s) to the Customer shall be independent transactions of
each other and separately documented.
■ However, according to Sharia’h perspective, it is preferable to appoint the Agent other
than the Customer.
■ Agency Agreement is not the condition of the Murabaha if the institution can make direct
purchases from the supplier.
■ It is advisable to execute Agency Agreement because financial institution does not have
the expertise to identify the Asset(s) and negotiate an efficient price.

PHASE II – DOCUMENTATION:

AGENCY AGREEMENT

■ This agreement must contain:

 Types (limited/Specific)
 Description of Asset(s) to be purchased
 Mode of Disbursement of Funds
 Roles and Responsibilities of Agent
 THESE DOCUMENTS MUST BE SIGNED BEFORE PURCAHSE OF
ASSET(S) BY THE AGENT

PHASE III & IV –

PURCHAHSE OF ASSETS BY AGENT

■ The Customer identifies the Vendor, selects the Asset(s) on behalf of the Bank and
advice its particulars, including the Vendor’s name and purchase price to the Bank.
■ If the supplier is nominated by the Customer itself, guarantee for good performance can
be demanded from the Customer.
■ The Customer takes possession of the Asset(s) as an Agent of the Bank.
■ It is the obligation of the Customer(Agent) to ensure, at this stage, that Asset(s) supplied
is in accordance with the given specifications.
■ To ensure that a fresh Asset(s) are purchased by the Agent, Bank’s staff should verify
actual purchase of Asset(s).

PHASE III & IV–DOCUMENTATION

DECLARATION FROM CUSTOMER (AGENT)

■ The Customer (Agent) will inform the Bank, through this document, that it has taken the
possession of Asset(s) on behalf of the Bank.
■ This Transactional Document shall be an integral part of Master Murabaha Financing
Agreement (MMFA).
 ■ This declaration must contain the statement that Customer has inspected the Asset(s) to
ensure its appropriateness and suitability to the customer.

Phase V
DISBURSEMENT OF FUNDS / PAYMENT TO VENDOR:

■ The Bank has two options regarding for payment of Purchase Price of Asset(s) bought by
Agent on its behalf.

a) Direct payment to Vendor by the Bank (preferable).

b) Disbursement of Funds to Agent’s (Customer’s) account for onward payment to Vendor
through Cross Cheque/Pay Order/Demand Draft etc.

PHASE VI
MURABAHA EXECUTION STAGE (OFFER AND ACCEPTANCE)

■ The Customer offers to buy the Asset(s) from the Bank which it has purchased as an
Agent of the Bank.
■ The Bank gives the Acceptance to the Customer’s Offer.
■ THIS IS THE POINT WHERE THE MURABAHA COMES IN TO EXISTENCE.
■ It is obligatory that the point when the risk of the Asset(s) is passed on by the Bank to the
customer be clearly identified.
■ It is mandatory to determine the Murabaha Price at this stage, otherwise Murabaha shall
not be valid.
■ It is also mandatory to determine the date of payment of Murabaha Price rendering the
Murabaha to be valid.

PHASE VI
MURABAHA EXECUTION STAGE DOCUMENTATION

■ This document must contain

i. Murabaha Price (Cost+Profit)

ii. Repayment Date

PHASE VII
PAYMENT OF MURABAHA PRICE BY CUSTOMER

■ Customer will pay the Murabaha Price to the Bank on the agreed date.
■ The customer is not entitled to any reduction in Murabaha price in case of
early payment of Murabaha Price.
■ In same way Bank can not increase the Murabaha Price if the Customer
defaults or make delayed payment.
Question 2:

Define and explain Salam. What is the background and purpose of Salam?
Elaborate its Shariah Legitimacy. Explain the key principles to follow while doing
Salam transactions? Also discuss parallel salam , agency agreement and
penalty for non-performance in SALAM? Also write about ISTISNA and its
conditions?

Furthermore, differentiate the following;

1. SALAM and Murabahah

2. ISTISNA and SALAM

Ans No. 2:

2- Salam Finance:

Definition:

A Salam is a contract whereby the purchaser pays the price in advance and
the delivery of subject matter (Goods) is postponed to a specified time in
future.

EXPLANATION:

Shariah does not permit selling what you do not own but Salam is exemptfrom this
condition. In Salam, as long as the commodity is specified by both quality and
quantityand at full payment at spot, it is allowed to sell it in a given future date. The
seller is obliged tohave the commodity by the end of contract. If the seller does not have
the commodity in hand atthe time of execution of the contract, he/she must buy it
in the market.Salam is similar toforward contracts in conventional financial system
with the difference that in Salam the entireamount must be paid when signing contract.

Purpose of Salam:
1. To meet the needs of small farmers who need money to grow their crops and to feed
their family up to the time of harvest.
 2. To meet the need of working capital

3. To meet the needs of liquidity problem.

4. To meet the need of traders for import and export business.

Background of Salam:
 Before prohibition of interest farmers used to get interest based loans for growing
crops and harvesting.

 After prohibition of interest, they were allowed to do Salam transactions. This

helped them to get money in advance for their needs.

Salam: Shariah Legitimacy

 Allah says “O you who believe when you deal with each other, in transactions
involving future obligations in a fixed period time, reduce them to writing” [2:282]

 Ibn Abbas reported, the Prophet (PBUH) came to Medina and found that people
were selling dates for deferred delivery (Salam) after a duration of one or two years.
The Prophet (PBUH) said: “whoever pays for dates on a deferred delivery basis
(Salam) should do so on the basis of specified quality, weight and time” [Bukhari
and Muslim]

Principles of Salam:
1. It is necessary for the validity of Salam that the buyer pays the price (Advance) in full to
the seller at the time of contracting the Salam, because the basic wisdom for allowing
Salam is to fulfill the instant need of the seller. If its not paid in full, the basic purpose will
not be achieved.

2. Only those goods can be sold through a Salam contract in which the quantity and quality
can be exactly specified.

3. All details in respect to quality of goods sold must be expressly specified and leaving no
ambiguity which may lead to a dispute.

4. It is necessary that the quantity of the commodity is agreed upon in absolute terms. It
should be measured or weighed in its usual measure.

5. The exact date and place of delivery must be specified in the contract.

6. There should be actual delivery of commodity, i.e., possession of goods must be

transferred.
PARALLEL SALAM:
 Parallel Salam is an arrangement by buyer to sell the commodity he purchased from some
one;

 The buyer can not sell the commodity before he takes the possession from seller in a
Salam contract as we discussed earlier;

 But the buyer may sell the commodity he bought it on Salm to another person on Salam
basis;

 This arrangement is called 'Parallel Salam';

Parallel Salam: important points:

 Parallel Salam is allowed with a third party only

 The seller in the first contract cannot be made purchaser in the parallel contract of Salam;
It will be a buy-back arrangement, which is not permissible;

 If the purchaser in the second contract is a separate legal entity, then it is necessary that it
should not be a subsidiary or sister concern of the seller company in the first contract;
The arrangement will not be allowed because in practical sense it will be a 'buy-back'
arrangement.

Agency agreement:
• If the bank has no expertise to sell the commodities received under Salam contract, then
the bank can appoint the customer as its agent to sell the commodity in the market/third
party, subject to Salam agreement and Agency agreement are separate from each other.

• A price must be determined in agency agreement on which the agent will sell the
commodity but if the price is increased, the benefit can be given to the agent.

Penalty for non performance:

• Seller can undertake in the Salam agreement that in case of late delivery of Salam goods,
he shall pay to the charity account maintained by the bank a sum calculated on the basis
of….% per annum for each day of default, bank will spend this amount in charity purpose
on behalf of the client.

Istisna:
Introduction
IT is asale transaction where commodity is transacted before it comes into existence
(Manufactured).
Definition:
• It is an order to producer to manufacture a specific commodity for the purchaser.

Conditions of Istisna:
• The subject of Istisna is always a thing which needs manufacturing.

• Manufacturer use his own material .

• Quality and Quantity should be agreed in absolute term.

• Purchase price should be fixed with mutual consent.

Difference b/w Salam & Murabaha:

Salam Murabaha

• In Salam, purchased goods • In Murabaha purchased goods

are deferred, price is paid are delivered at spot, price of
on spot. goods deferred in future.

• In Salam price has to be • In Murabaha price may be in

paid in full in advance. lumpsum or in installments.

Difference between Salam and Istisna:

Istisna Salam

• Time of Delivery does not have to be • Time of delivery is an

essential part of the
fixed, but the stages of manufacture
sale.
might be time bound.
• The contract cannot
• The contract can be cancelled before the be cancelled
unilaterally.
manufacturer starts working.